Is economy/markets a house of cards?

The S&P 500 continues to hit new all-time highs, but is your portfolio built on a house of cards? The politics to kick the proverbial can down the road may unleash dynamics that could be hazardous to your wealth.

The one thing politicians throughout the world have in common is that they rarely ever blame themselves. They tend to diffuse responsibility or place blame on groups such as political opponents, the wealthy, or foreigners.

If you now add that we have very real and major challenges in the world, it may be reasonable to assume that policy makers will continue to remain engaged in “fixing” things by blaming others. As an investor, if nothing else, this means asset prices may continue to move away from fundamentals and reflect the next perceived intervention by policy makers. This presents challenges for investors trying to maintain the real purchasing power of their portfolio and avoid a major drawdown at the wrong time.

Going forward we may continue to see less political stability as weakness in the real economy breeds discontent. In the U.S., they vote for more populist politicians, helping to explain the rise of the Tea Party and the Occupy Wall Street movement. In the Middle East, where rising food and energy prices comprise a much bigger portion of disposable income, people revolt as they can’t feed themselves anymore. In Japan, Abenomics is introduced by a populist prime minister.

Meanwhile both monetary and fiscal policy create a more challenging landscape for real economic prosperity to emerge. Instead of a rebirth following the global financial crisis we get a phony house of cards that may come down on the heads of investors who think that policy makers have their best interests in mind.

One of the most relevant dynamics for investors to be aware of is that the interests of a government in debt are not aligned with the interests of investors. A government in debt has an incentive to debase the value of its debt, whereas investors have an interest in earning a positive real return on their savings.

Last week, I attended a conference at Stanford’s Hoover Institution, where academics, as well as four acting Fed Presidents, pondered about the future of central banking. One of the presenters, Stanford Professor Dr. Martin Schneider, had some blunt words that were as obvious as they were controversial: monetary policy cannot be conducted in a vacuum, and is very much dependent on fiscal policy. He pointed out that as interest rates rise, taxes would have to go up to pay for the higher cost of servicing the debt.

Dr. Schneider presented a simplified model of the world, arguing that in the U.S., in today’s environment, both government and citizens would benefit from inflation- the losers are foreigners. Now anyone can take issue with a simplified model; and I could also argue why everyone loses with inflation. Such details should not distract from the message, though:

Inflation debases the value of government debt

Inflation debases the value of consumer debt

If you are a consumer with savings, sorry, you are in the minority and your interests will have to take a back seat

Given that foreigners hold large amounts of Treasuries, they are on the losing end in an inflationary environment

We can argue whether inflation is a problem today or whether it is not. But it’s difficult for me to argue with the above. The conclusions I draw are:

Political stability throughout the world will continue to decline

Traditional diversification can’t be relied upon as asset prices reflect the next perceived move of policy makers rather than fundamentals

Asset bubbles will be fostered

Bonds are vulnerable

The U.S. dollar is vulnerable

Investors may need a toolbox to counter the toolbox of policy makers

The investment tools we have been focusing on to tackle these challenges at the core are currencies and gold. Gold may do well as the value of debt (and with it the dollar) is debased; gold also has historically had a low correlation to other asset classes, thus serving as a candidate diversifier going forward. Currencies can also serve as valuable tools: with currencies, one can design a portfolio that has a low correlation to other asset classes; currencies are historically less volatile than gold. On the other hand, other countries also face challenges, so some thought has to be put into a currency driven strategy.

We can’t know for certain that either currencies or gold will protect investors against a collapse of the proverbial house of cards, but we are afraid that ignoring these dynamics could be perilous.

About the Author

Axel Merkthe president and chief investment officer of Merk Investments, the authority on currencies, and manager of Merk Funds, a suite of no-load currency mutual funds that typically do not apply leverage.